How To Find Out If A Mutual Fund Is Mispricing A Stock

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1 Insider Trading and Option Grant Timing in Response to Fire Sales (and Purchases) of Stocks by Mutual Funds Ashiq Ali School of Management Universy of Texas at Dallas 800 W. Campbell Rd. SM 41 Richardson, TX (972) Kelsey D. Wei School of Management Universy of Texas at Dallas 800 W. Campbell Rd. SM 31 Richardson, TX (972) Yibin Zhou School of Management Universy of Texas at Dallas 800 W. Campbell Rd. SM 41 Richardson, TX (972) November 2009 We thank the seminar participants at the National Universy of Singapore and the Universy of Texas at Dallas for helpful comments. All errors are our own.

2 Insider Trading and Option Grant Timing in Response to Fire Sales (and Purchases) of Stocks by Mutual Funds Abstract Mutual funds experiencing large outflows (inflows) tend to decrease (expand) existing posions, creating downward (upward) price pressure in the stocks held in common by them (Coval and Stafford 2007). This study shows that corporate insiders explo the resulting mispricing by buying (selling) their company s stock if is subject to such fire sales (purchases) by funds. We also show that the likelihood of option grants is greater for stocks that are under mutual fund fire sales. Finally, we show that both the insider trading and the option granting activies help speed up the price correction of the flow-driven mispricing. Overall, this study illustrates that insiders enhance personal benefs by trading on their personal account and influencing the timing of option grants in response to flow-driven forced fund trading. Moreover, these activies contribute significantly towards improving the informational efficiency of stock price.

3 Insider Trading and Option Grant Timing in Response to Fire Sales (and Purchases) of Stocks by Mutual Funds I. Introduction Coval and Stafford (2007) show that trades by mutual funds experiencing extreme capal flows create significant price pressure in the securies held in common by these funds. In this study, we examine activies for personal benefs that corporate insiders undertake to explo this type of mispricing resulting from the fire sale (purchase) of their company s stock by mutual funds. We also examine the price impact of such activies. Specifically, we address the following broad questions. First, do corporate insiders trade on the misvaluation of their own company s stock? Second, do insiders influence the timing of their option grants in order to explo this type of mispricing? Finally, do the insider trading and the option granting activies help speed up the correction of mispricing? Answers to these questions are important to assess the role of insider trading and option grant timing in improving the informational efficiency of prices. Although a few accounting and finance studies have examined insider trading on mispricing, there is ltle evidence on the other two questions. Rozeff and Zaman (1998), Piotroski and Roulstone (2005), and Jenter (2005) show that net insider buying is greater in value firms and firms wh lower past returns. They conclude that managers explo the mispricing of their company s stock by buying (selling) stocks that they perceive as undervalued (overvalued). In another strand of lerature, Core, Guay, Richardson and Verdi (2006) assume that insiders recognize potential mispricing of their own equy and test the accruals and post-earnings announcement drift (SUE) anomalies by relating insider trading activy to trading strategies suggested by these anomalies. They find mixed results in that there exists corroborative evidence for the accruals anomaly but not for the SUE anomaly. 1

4 Our study complements these prior studies by examining insider trading associated wh a different type of mispricing than the ones examined by the above studies. Due to regulatory and self-imposed investment restrictions, mutual funds facing significant inflows or outflows must quickly adjust their underlying posions if they don t have much flexibily wh their cash reserves. 1 Given the large size of fund flows and market frictions that prevent immediate liquidy provision, the resulting trading activies of these funds may push stock price significantly away from s fundamental value if too many funds experiencing flow shocks are buying or selling the same posions at the same time. Consistent wh this view, Coval and Stafford (2007) show that funds experiencing large outflows (inflows) tend to reduce (increase) their existing posions, exerting significant price impact on stocks in the overlapped holdings of these funds. Since these flow-induced trades are due to necessy at the fund level, rather than to information about their underlying secury holdings, the resulting mispricing is largely exogenous to firm fundamentals. Indeed, Coval and Stafford (2007) find evidence of significant price reversals following this type of forced transactions. On the other hand, they do not find stocks that are subject to widespread selling by unconstrained mutual funds to experience subsequent return reversals. Thus, insider trading in response to flow-driven mutual fund trades is unlikely to be due to insiders private information on the firm s future performance or firm characteristics. Rather, is more likely to be motivated by their incentive to explo the mispricing of their own stock. Furthermore, since Coval and Stafford (2007) estimate that investors providing liquidy to flow-constrained funds earn significant abnormal returns over the subsequent months, there should exist a strong incentive for insiders to act as arbrageurs. 1 Coval and Stafford (2007) document that actively managed equy mutual funds maintain around 4 percent of their total net assets in cash. 2

5 For the sample period of 1987 to 2007, we show that net insider demand increases (decreases) significantly for stocks that are subject to mutual fund fire sales (purchases). Specifically, net insider demand of a stock increases by almost 0.05% of shares outstanding when a stock changes from a target of mutual fund inflow-driven purchases to a target of outflow-driven fire sales. This amount is about two times the median level of insider trading. This finding is robust to controlling for the overall mutual fund trading of the stock driven by factors other than extreme capal flows, e.g., private information on firm value. It is also robust to controlling for other previously identified determinants of insider trades, including insiders liquidy related trades, their recent option exercises, the firm s book-to-market ratio and past stock performance. Furthermore, we show that the relation between mutual fund forced trading and insider trading is more pronounced for smaller and less liquid stocks, consistent wh mutual fund forced trades leading to greater mispricing for these types of stocks. Finally, similar to the findings in prior studies (e.g., Piotroski and Roulstone 2005), we provide evidence that net insider demand for a stock is posively related to the firm s future profabily. However, this relation becomes significantly weaker when insiders trade in response to mutual fund flowdriven price pressure, consistent wh the interpretation that this type of insider trading is unrelated to firm fundamentals. Overall, our findings demonstrate that insider trading in response to mutual fund fire sales (purchases) is driven, at least in part, by the incentive to explo the resulting mispricing. Next, we examine the effect of insider trading on the speed of price correction in the context of mutual fund flow-driven price pressure. This is an important question because for a long time the proponents of insider trading have argued that insider trading increases the information content of prices (Manne 1966a, b; and Carlton and Fischel 1983). One could argue 3

6 that if insiders trade on the mispricing of their company s stock, this activy should result in price correction. However, is not obvious that trading by insiders on their personal account can provide enough liquidy to significantly reduce the mispricing. The price correction effect of the insider trading activy would, however, be enhanced if other market participants use insider trades as a signal that the firm s stock is mispriced and trade accordingly. The effectiveness of insider trading in achieving quicker price correction is therefore an empirical question. Our results indicate that if mutual fund extreme flow-driven trades are followed by insider trading in the oppose direction, subsequent return reversals are significantly smaller. These results hold after controlling for firms concurrent net stock issues in response to flowdriven mispricing and firm characteristics such as size, book-to-market, and past returns. Thus, insider trading against flow-constrained mutual fund trades helps arbrage away the mispricing and speeds up the process of price correction. Lastly, our study provides further evidence on the issue of whether managers explo the mispricing in their company s stock for their own benef, by examining whether insiders influence the timing of option grants in response to mutual fund flow-driven price pressure. We find that the odds of a grant issue in the quarter following fire sales by constrained mutual funds is greater by approximately 16.33%, relative to the odds in other quarters. This result suggests that managers explo the mispricing of their firm s stock by influencing the timing of option grants. We also examine the incremental effect on price correction when the company grants options soon after mutual fund fire sale of s stock. We find that option grant timing helps reduce subsequent return reversals, even after we account for the price-correction effect of related insider trading in the same period. Therefore, seems that other market participants view the timing of option grants as an undervaluation signal, and accordingly, trade on the stock. 4

7 This study makes the following contributions to the lerature. First, several recent studies (see, e.g., Rozeff and Zaman 1998; Jenter 2005; and Piotroski and Roulstone 2005) have examined whether insiders trade to explo the mispricing in their company s stock. These studies consider valuation ratios, such as book to market ratio and past returns, as proxies for mispricing. However, as these studies acknowledge, there could be alternative interpretations of their findings. For example, managers of a low book to market ratio firm may be more likely to sell their company s shares, simply because growth firms are more likely to compensate their managers wh equy (Smh and Watts 1992). Furthermore, Piotroski and Roulstone (2005) argue that the findings of these studies may simply be attributed to insider trading on the basis of superior information about future cash flows because firms wh high book to market ratio and negative past returns tend to experience posive future earnings announcement returns (La Porta, Lakonishok, Shleifer, and Vishny 1997). They address this concern by controlling for insider trading due to future cash flow news. We complement these studies by considering price pressure due to mutual fund flowdriven trades as the source of mispricing. This measure is unlikely to be related to firm characteristics, such as risk and growth, and is therefore less susceptible to alternate interpretations. A concurrent working paper, Khan, Kogan, and Serafeim (2009) examine whether managers time the company s SEOs and their personal stock sales in response to mutual fund buying pressure. In comparison to their main interest, the timing of SEOs, the focus of our paper is on insider activies that enhance their personal benefs and the resulting impact on stock prices. These activies include both trading on their personal account and influencing the timing of stock option grants. Thus, we make further contribution to this lerature by showing that influencing the timing of option grants is another channel through which insiders can explo 5

8 the temporary mispricing of their stock. Our study also examines the impact of both these activies on the speed of price correction, which Khan et al. (2009) do not. Recently, Ben-David and Roulstone (2009) show that insider trades are contrarian and the abnormal returns from such trades are greater for stocks wh higher idiosyncratic risk. They argue that since idiosyncratic risk proxy for the cost of arbraging, their evidence is consistent wh insiders acting as arbrageurs when their own firm s stock is mispriced. Our result supports this view. However, our study is distinct in that directly examines whether insider trading and the company s option granting activy help correct the mispricing of the stock. The finding that both activies help speed up the price correction process supports the argument that insiders attempt to explo the mispricing can improve the price efficiency of the stock through both direct liquidy provision and s signaling effect that encourages further liquidy provision by other market participants. In other words, insiders improve market efficiency not only by acting as arbrageurs, but by facilating arbrage activy of other investors. Our finding that the timing of option grants coincides wh the mispricing of the stock, also contributes to the accounting and finance lerature on option grants timing. Prior studies have shown that executives option awards coincide wh negative abnormal returns before the grant date and posive abnormal returns afterwards. Explanations put forth for this finding include (i) managers receive stock option awards shortly before their company s favorable quarterly earnings announcements (Yermack 1997), (ii) managers delay voluntary disclosure of good news and rush forward voluntary disclosure of bad news before the stock option award date (Aboody and Kasznik 2000; Chauvin and Shenoy 2000), (iii) back-dating of prior issues (Lie 2005; Bernile and Jarrell 2009), and (iv) forward-dating of current issues (Narayanan and Seyhun 2008). We add to these explanations by providing evidence consistent wh the notion 6

9 that managers are aware of the undervaluation of their company s stock due to fire sales by distressed mutual funds, and that they explo this misvaluation by influencing the timing of option grants. Note that compared to other forms of opportunistic timing of option grants, such as the manipulation of information disclosure and misdating, the timing of option grants in response to temporary downward pressure on share price would be more desirable for insiders, because can be implemented based upon public information and will not cause any obvious legal problems. The rest of the paper is organized as follows. In Section II, we describe our data and methodology. Section III examines the response of insider trading to mutual fund flow-driven price pressure. Section IV illustrates the effect of insider trading following mutual fund fire sales/purchases on the speed of price correction. Section V explores the relation between mutual fund flow-driven trading pressure and the timing of option grants, and the effect of such timing activy on the correction of mispricing. Section VI concludes the paper. II. Data and Methodology 1. Measuring Mutual Fund Trades To examine price pressure due to mutual fund trades that are forced by extreme flows, we follow Coval and Stafford (2007) and construct a stock level price pressure measure. We collect fund information from two databases. First, we obtain quarter end snapshots of portfolio holdings for domestic equy mutual funds during the period of 1987 to 2006 from Thomson Financial, and we infer fund purchases and sales from changes in their quarterly posions. 2 Quarterly portfolio holdings are adjusted for stock spls and dividends using the end-of-quarter 2 For funds not reporting at the end of a given quarter, we carry forward (for a maximum of three months) their most recent holdings to calculate trades during the following quarter. 7

10 cumulative adjustment factor from CRSP. We focus on trades made by actively managed, diversified U.S. domestic equy funds, and exclude all trades by index funds, international funds, municipal bond funds, bond and preferred funds, and sector funds. Next, we obtain fund returns and total net asset value from the CRSP Survivorship Bias Free Mutual Fund Database. These two mutual fund databases are then linked via the MFLINKS dataset provided by WRDS. To identify funds experiencing extreme flows, we compute quarterly fund flows as the change in total net assets during the quarter, adjusted for investment returns (assuming flows occur at the end of each quarter). That is: Flow jt TNA = jt TNA TNA jt 1 (1 + jt ) jt 1 R (1) where TNAjt is the total net assets of fund j at the end of quarter t, and R jt is the quarterly return of fund j during quarter t. Note that since different share classes of a fund represent claims to the same underlying portfolio, there is no difference in their underlying holdings and trades. Therefore, we combine quarter-end total net assets across all share classes of each fund, and calculate fund returns as the weighted average of returns across share classes wh the weight as the beginning-of-quarter total net asset value. 3 A fund is considered as experiencing extreme capal flows if has realized flows above/below the 90 th /10 th percentile among all funds during the quarter. Next, we sum up all inflow-driven purchases and outflow-driven sales made by funds trading a stock in a given quarter. We then normalize the difference by the firm s shares outstanding at the beginning of the quarter, obtained from the CRSP monthly stock database. The flow-driven price pressure measure of the stock is defined as, 3 We winsorize quarterly flows at the top and the bottom 2.5 percentiles to minimize the impact of outliers in fund TNA due to mergers and spls. Our results remain qualatively unchanged if we exclude these extreme observations. 8

11 Forced_ Raw = j (max(0, Δholdings j ) flow jt > percentile(90th)) SharesOutstnding j (max(0, Δholdings i, t 1 j ) flow jt < percentile(10th)) (2) where holdings j is the change in fund j s holding of stock i in quarter t, and flow jt is the capal flow for fund j in quarter t. To calculate this measure, we require a stock to be owned by at least five funds. Essentially, Forced_Raw measures the degree to which a stock s trading is accounted for by mutual funds experiencing significant inflows or outflows. Lastly, stocks wh Forced_Raw above the 90 th percentile (below the 10 th percentile) among all stocks during the quarter are considered as fire purchase (sale) stocks. We classify stocks using a discrete variable, Forced, that takes the value of -1 for fire sale stocks, +1 for fire purchase stocks, and 0 otherwise. Unlike mutual fund forced trades, Coval and Stafford (2007) show that there is no price reversal after voluntary mutual fund trading. This is consistent wh the view that unconstrained fund trading contains information about firms fundamental value. In addion, Sias and Whidbee (2008) find that insider trading is, in general, negatively related to instutional demand. Therefore, we control for trades by unconstrained funds in our insider trading analysis. Specifically, we measure these trades as: Unforced = j Δholdings j percentile(10th) <= flow Shares Outstanding jt i, t 1 <= percentile(90th) (3) This measure is similar to the dollar trade imbalance ratio used in Lakonishok, Shleifer, and Vishny (1992). To differentiate from flow forced trades, we only sum up the trades made by those mutual funds that are not in their top or bottom 10% according to their quarterly percentile ranks of capal flows. 9

12 2. Measuring Insider Trading We obtain insider trading data from the Thomson Reuters Insider Filing Data Files for the 1987 to 2007 period. To facilate a comparison to previous studies (Rozeff and Zaman 1998; Piotroski and Roulstone 2005; and Sias and Whidbee 2008), we focus on open market transactions and define insiders as the directors and officers of a company, since they are the people who are most likely to possess information about the company s fundamentals and be able to identify and explo the potential mispricing of their company s stock. To avoid filing errors, we exclude duplicate filings, insider buying and selling of fewer than 100 shares or more than 20% of the firm s total shares outstanding, and transactions whose trade prices deviate from CRSP prices by more than 50%. We calculate net insider demand as the net number of shares purchased by all insiders during the quarter as a fraction of prior-quarter shares outstanding: (# of shares purchased # of shares sold ) NID = # of shares outstanding (4) 1 3. Option Grants We also investigate whether stock options granted to insiders are timed to take advantage of the mispricing following mutual fund flow-driven trades. Our option grants data is extracted from the Thomson Reuters Insider Filing Data Files. We focus on the period 1995 to 2007 since option grants data is sparse until the mid 1990s when equy based compensation became a more popular form of executive compensation. Following prior research on the timing of option grants (Heron and Lie 2007), we consider transactions wh code A (grant or award transaction pursuant to Rule 16b-3(c)) and combine any duplicate filings of grants that are awarded to a given individual in a given company during a given quarter. A grant event is then indicated by a discrete variable taking the value of 1 if one or more officers and directors receive option grants 10

13 during the quarter, and 0 otherwise. Our grants sample contains 95,310 insider grant events in 10,144 firms during the sample period. 4. Other Control Variables When examining the effect of mutual fund trading-induced price pressure on insider trading, we control for a set of variables that have been shown in prior studies to explain insider trading. First, we include book-to-market ratio (B/M) and cumulative returns during the past 12 months (Past Return) to control for insider trading due to their contrarian belief about firm value. B/M is calculated as the ratio of book value to market value of equy as of the prior December. 4 Following Rozeff and Zaman (1998), Past Return is also used to control for insider trading due to portfolio rebalancing since their ownership of the firm varies wh stock price. To control for autocorrelation in net insider demand, i.e., insiders normal propensy to buy/sell stocks for liquidy reasons, we use Past NID, defined as the average net insider demand over the past four quarters. Rozeff and Zaman (1988) show that net insider demand is related to firm size. Thus, we control for firm size (LogSize), defined as the logarhm of firms market capalization as of the previous quarter end. Piotroski and Roulstone (2005) show that insiders are more likely to sell after exercising stock options, we therefore construct a binary variable, Optex, which takes the value of 1 if one or more insiders exercise one or more options during the quarter, and 0 otherwise. Furthermore, given the requirement prior to May 1991 that insiders hold stocks acquired through option exercises for at least six months, we set Optex to 1 if insiders exercise any option during the prior two quarters, and 0 otherwise, for the sample period before the second quarter of We measure the book value of equy as (total assets - total liabilies - preferred stock) + deferred taxes + convertible debt, and the market value of equy as common shares outstanding multiplied by price. The book-tomarket ratio as of December of year t-1 is then applied to July of year t to June of year t

14 Finally, we account for the relation between net insider demand and the future profabily of the firm. We measure a firm s profabily as changes of s industry adjusted return-on-assets (ROA). ROA is calculated as Compustat quarterly income before extraordinary em divided by the prior-quarter s total assets. We then subtract from the industry median of the quarter to obtain the industry-adjusted ROA, using the Fama-French (1992) 48 industry classification. Our final sample contains 197,351 quarterly observations of insider trades in 12,843 firms during 1987 to Descriptive statistics of the main variables are reported in Table 1. The median net insider demand is -0.02%, suggesting that, in general, insiders sell more than they buy, consistent wh their liquidy driven trading needs resulting from their equy-based compensations. The summary statistics for the other variables are similar to those in prior studies. III. The Effect of Mutual Fund Flow-Driven Trades on Insider Trading 1. Insider Trading against Mutual Fund Flow-Driven Trades Coval and Stafford (2007) find that widespread buying and selling of stocks held in common by mutual funds experiencing extreme capal inflows cause stock prices to deviate significantly from fundamental value. Since the misvaluation caused by mutual fund flow-driven trades is largely exogenous because affects stock price but has ltle to do wh firm fundamentals, provides an ideal setting to test whether insiders trade on misvaluation of their company s stock. Specifically, insiders should buy more (or sell less) of their stock when is subject to fire sales by distressed mutual funds; likewise, insiders should sell more (or buy less) of their stock when is subject to mutual fund inflow-driven purchases. We test this hypothesis by regressing net insider demand on the discrete variable indicating mutual fund flow-forced 12

15 trades (Forced), controlling for other factors that have been documented to determine insider trading. Specifically, we estimate the following equation: NID = α + β Forced β2 / + β Optex + β LogSize B M 1 + β Unforced 7 + β Past Return ε 4,t 1 + β Past NID 4 4,t 1 (5) where NID is the net insider demand in percentage, measured as the net fraction of firm i's shares purchased by officers and directors in quarter t. Forced is a discrete variable that takes the value of -1 for stocks that are ranked in the bottom decile according to the Forced_Raw measure (i.e., fire sale) in quarter t-1, 1 for stocks that are ranked in the top decile (i.e., fire purchase) in quarter t-1, and 0 otherwise. B/M is the book to market ratio as of the prior December. Past Return is firm i s cumulative returns over the past 12 months. Past NID is the average quarterly net insider demand in percentage over quarters t-4 to t-1. Optex is a dummy variable that equals 1 if firm i s insiders exercise stock options in quarter t, and 0 otherwise. LogSize is measured as the logarhm of firm i s market capalization at the end of quarter t-1. Unforced represents mutual fund trading imbalance of firm i's shares in quarter t-1 that is not driven by extreme flows, as against trades forced by extreme capal flows. Finally, we include industry and time fixed effects and calculate t-statistics using robust standard errors that adjust for clustering by firm. Table 2 presents coefficient estimates of equation (5). To facilate the comparison of our results to those in the lerature, we first report in column (1) the effects of previously identified determinants of insider trading. Consistent wh insiders being contrarian traders (Rozeff and Zaman 1998; Jenter 2005; Piotroski and Roulstone 2005), net insider demand is inversely related to the firm s past 12-month returns and posively related to s book-to-market ratio. In addion, the negative coefficient on Past Return may reflect insiders effort to rebalance their portfolios for diversification purposes. The significantly posive coefficient on Past NID indicates posive 13

16 autocorrelation in insider demand. We also find that net insider demand decreases wh Optex, consistent wh the notion that insiders are more likely to sell when they have recently exercised options (Piotroski and Roulstone 2005; Sias and Whidbee 2008). The posive relation between net insider demand and firm size is consistent wh the finding in Lakonishok and Lee (2001) that insiders activies are more pronounced for small firms than for large ones in terms of both purchases and sales. Since insiders, in general, sell more than they buy, is more likely to observe a lower net insider demand if their company is small than if is large. Lastly, we observe an inverse relation between insider trading and instutional demand by unconstrained funds, consistent wh Sias and Whidbee (2008). The model in column (2) captures the relation between mutual fund flow-driven price pressure and insider trading. As expected, the coefficient on Forced is significantly negative. When a stock swches from a target of mutual fund inflow-driven purchases to a target of outflow-driven sales, net inside demand increases by close to 0.05% of total shares outstanding. This result supports our hypothesis that insiders are able to identify and trade on the misvaluation caused by mutual fund flow-forced trades. That is, insider purchases increase significantly following mutual fund outflow-driven fire sales of their company s stock and insider sales increase significantly following mutual fund inflow-driven purchases. 5 5 We re-estimate the model in Table 2 using an alternative measure of insider trading, net purchase ratio (NPR), given that is used in some of the prior studies (see, e.g., Rozeff and Zaman 1998; and Piotroski and Roulstone 2005). NPR is defined as the number of shares purchased divided by the sum of the number of shares purchased and the number of shares sold by insiders. Compared to net insider demand (NID), NPR emphasizes insider purchases because the net purchase ratio of a firm whose insiders do not make any purchases during a period does not vary wh the amount of insider sales. Our results remain qualative the same based on NPR. We also re-estimate the model in Table 2 after replacing the binary variable Forced wh s continuous counterpart Forced_Raw (see equation 2). Our results are once again robust to this alternate measure. 14

17 2. The Effect of Stock Liquidy The result in Table 2 is consistent wh our hypothesis that insiders take advantage of the misvaluation caused by forced trades of mutual funds experiencing extreme flows by trading against these funds. If this type of temporary price pressure is indeed due to the low supply of liquidy in the short-run (rather than due to firm fundamentals), should be more severe for illiquid stocks. That is, the more illiquid a firm s stock is, the more s stock price should deviate from s fundamental value after concentrated purchases and sales by mutual funds. In that case, net insider demand would also be more sensive to Forced. We examine this issue by augmenting Equation (5) wh an interaction term between Forced and a measure of stock liquidy: NID = α + β + β Past Return 5 1 Forced 1 + β2illiquidy 1 + β3forced 1 Illiquidy 1 + β4b / 4, t 1 + β Past NID 6 4, t 1 + β Optex + β LogSize M 1 + β Unforced ε (6) Following prior lerature, we use two variables to proxy for stock liquidy: firm size and the Amihud (2002) illiquidy measure. The raw Amihud (2002) illiquidy ratio is calculated as the absolute daily return divided by the dollar trading volume (number of shares traded multiplied by end-of-day stock price), averaged over the quarter. Since NYSE/AMEX and NASDAQ report trading volume differently, we construct an adjusted Amihud illiquidy measure as the raw Amihud (2002) illiquidy ratio standardized by the average value of the ratio for all stocks traded in the same exchange. In addion, to reduce the noise in the construction of this measure, we exclude stocks wh a price lower than $5 and wh less than 30 daily return observations during the quarter when estimating Equation (6). Columns (1) and (2) of Table 3 report regression estimates of equation (6) wh stock illiquidy proxied by size and the adjusted Amihud (2002) illiquidy measure, respectively. We expect a posive coefficient on the interaction term, Forced*LogSize, and a negative coefficient on the interaction term, Forced*Illiquidy, because mutual funds forced trades will exert greater 15

18 price pressure on more illiquid stocks providing insiders wh better arbrage opportuny. Column (1) shows that the coefficient on Forced remains significantly negative. More importantly, the coefficient on the interaction term between Forced and LogSize is significantly posive, suggesting that the negative relation between insider trading and mutual fund forced trades is weaker for large firms that are more liquid and therefore suffer smaller mispricing. Similarly, column (2) shows that both the coefficient on Forced and that on Forced*Illiquidy are significantly negative. These results further suggest that mutual fund flow-driven price pressure is caused by a delay of liquidy provision, and that insiders trade those illiquid stocks more aggressively to explo their greater mispricing. 3. Further Evidence of Insider Trading on Mispricing Since mutual fund flow-driven trades are largely exogenous to firm fundamentals, our results in the previous section are consistent wh the notion that insider trading against mutual funds is motivated by the incentive to explo market misvaluation of their own company s stock, rather than by insiders private information about the firm s future cash flows. In this section, we provide further support to this conclusion by relating insider trading to changes in the firm s future operating performance. Since Ke, Huddart, and Petroni (2003) find that insiders trade on the knowledge of significant forthcoming accounting disclosures as long as two years prior to the disclosures, we focus on a firm s cash flow news during the one and two years following insider trading. Particularly, we examine the relation between insider trading in response to mutual fund flow-driven price pressure and subsequent changes of the firm s operating performance. For this purpose, we estimate the following model: ΔROA + 1, t+ 4 + β LogSize 5 = α + β NID + β Unforced β Forced ε 1 + β NID 3 Forced 1 + β Past Return 4 3,t (7) 16

19 where ROA is the change in firm i s industry-adjusted ROA following insider trading, calculated by subtracting the average industry-adjusted ROA in quarter t-4 to quarter t-1 from that in quarters t+1 to t+4 (or quarters t+1 to t+8). In addion, we include time dummies to control for differences in operating performance over time. All t-statistics are calculated wh standard errors that are adjusted for clustering by firm. Since Ke et al. (2003), Piotroski and Roulstone (2005), and Cheng, Nadar and Rajan (2007) find that insider trading is informative of a firm s future operating performance, we expect the coefficient on NID to be posive. Furthermore, we expect that the predictive power of insider trading on the firm s future profabily becomes weaker, when insider trading following mutual fund forced trades is motivated by the intention to explo the resulting mispricing. In other words, if insiders trade to explo valuation errors, their trading should have less predictive power for future cash flows. Before examining the interaction between mutual fund flow-driven price pressure and insider trading, in Panel A of Table 4 we first report the uncondional effect of insider trading on future cash flows. The result shows that changes in future operating performance, in general, are posively related to net insider demand, consistent wh insider trading being predictive of a firm s future operating performance. This finding holds whether we examine changes of ROA during quarters t+1 to t+4 or during quarters t+1 to t+8, relative to quarters t-4 to t-1. Furthermore, to examine the relative importance of insider purchase versus insider sale in predicting future cash flows, we spl NID into two variables: NID_Posive and NID_Negative. NID_Posive is set to equal NID if NID is non-negative, and 0 otherwise. NID_Negative is set to equal NID if NID is negative, and 0 otherwise. The results in columns (2) and (4) indicate that the coefficient on insider purchases is significantly larger than that on insider sales. This confirms previous findings that insider purchases are more informative than insider sales, 17

20 because insiders tend to sell for liquidy or portfolio rebalancing reasons that are unrelated to a firm s future performance. On the other hand, the insignificant coefficient on Forced confirms the argument in Coval and Stafford (2007) that mutual fund forced trades are not related to the firm s future profabily. Finally, a firm s future profabily is significantly posively related to Unforced, suggesting that aggregate trading by unconstrained mutual funds is likely to be driven by their private information. Panel B reports regression estimates of equation (7). To differentiate the case of net insider sale (NID < 0) following mutual fund fire sale (Forced = -1) from the case of net insider buy (NID > 0) following mutual fund fire purchase (Forced = 1) when interacting NID wh Forced, we transform net insider demand into a non-negative measure. For columns (1) and (2), we define NID as a dummy variable that takes the value of 1 when net insider demand is posive or zero, and 0 when net insider demand is negative. In the case of stock underpricing due to mutual fund outflow-driven fire sale (Forced= -1), if insiders increase their posion to prof from the mispricing (NID = 1), insider purchases should be less related to the firm s future operating performance. Thus, we predict a posive coefficient on the interaction term NID*Forced. On the other hand, when the stock is overpriced as a result of inflow-driven purchases (Forced = 1), if insiders still decide to increase their holdings of the stock (NID = 1), insider purchase should be even more predictive of the future performance of the firm. Hence, once again we predict a posive coefficient on the interaction term. The results reported in columns (1) and (2) of Panel B strongly support these predictions. That is, while NID has strong predictive power for future changes in ROA, the interaction term NID*Forced has a significantly posive coefficient. Furthermore, these results are robust to using NID decile rank variable in place of the NID dummy variable (see columns 3 and 4). Overall, the evidence in this section 18

21 suggests that insiders trading in response to mutual fund flow-driven trades is at least in part driven by their motivation to explo mispricing of their firm s stock. IV. Insider Trading and the Speed of Price Correction Coval and Stafford (2007) show that the price pressure on stocks due to concentrated mutual fund sales and purchases forced by extreme money flows takes more than a year to correct. They argue that the speed of price correction depends on the extent of liquidy provision to these constrained funds. Our result in the previous section shows that corporate insiders provide liquidy to constrained funds as they take advantage of this type of temporary mispricing. Also, these insider trades would encourage other arbrageurs to provide liquidy as well, because they would be more confident that the stock is mispriced after observing insider trading activies. Liquidy provision through both channels should speed up the price recovery process. 6 We use the following baseline model to test the price impact of insider trading: ARET + 1, t+ 8 = α + β Forced_ Sell β Forced_ Sell 1 1 β LogSize + β B/ M β Forced_ Buy 2 + β Past Return 1 * Insider_ Buy + β Forced_ Buy 8 5 3,t + β Insider_ Buy β Unforced 9 1 * Insider_ Sell + + ε (8) where ARET +1.t+8 denotes stocks abnormal returns during the eight quarters following insider trading. We employ two alternative measures of abnormal returns. First, following Coval and Stafford (2007), we measure stocks quarterly returns in excess of the equal-weighted average quarterly return of all stocks held by mutual funds at the beginning of the quarter. This measure 6 Consistent wh this argument, Hong, Wang and Yu (2008) show that firm intervention makes less risky for other market participants to provide liquidy to s stock should be mispriced. 19

22 of abnormal returns controls for the overall performance of stocks held by mutual funds. Second, we consider quarterly rebalanced DGTW (1997) characteristics-adjusted abnormal returns, which is a stock s raw quarterly return in excess of the return of s matching characteristic-based benchmark portfolio. To form the benchmark portfolios, we follow DGTW (1997) and sequentially sort all common stocks listed on the NYSE, AMEX, and NASDAQ into quintiles along the dimensions of market capalization, book-to-market ratio, and past 12-month returns. This sorting results in 125 benchmark portfolios. We calculate the value-weighted returns for each benchmark portfolio. 7 The advantage of using the DGTW (1997) characteristic-adjusted abnormal return is that controls for common return predictive stock characteristics using a nonparametric approach and therefore does not restrict factor loadings to be constant over time. Note that to provide stronger control for short term stock momentum, we adjust returns wh quarterly (instead of annually) rebalanced DGTW benchmark portfolio returns. Since Coval and Stafford (2007) document that the temporary price pressure of inflow and outflow-driven fund trades takes more than a year to fully reverse, we measure stocks cumulative abnormal returns during the eight quarters following insider trading, quarters t+1 to t+8. Furthermore, we also separately examine the cumulative abnormal returns for the period of quarters t+5 to t+8, since Coval and Stafford (2007) argue that the price pressure caused by flowdriven fund trades may persist inially before reversing self. To account for abnormal returns that are due to instutional trading imbalance that is unrelated to extreme flows, we include Unforced measured in the same quarter as Forced as a control variable. We also include firm size (LogSize), book to market ratio (B/M) and the past 12 months returns (Past Return) ending in quarter t as addional control variables because they help capture co-movements among 7 See Daniel, Grinblatt, Tman, and Wermers (hereafter DGTW 1997) and Wermers (2004) for details on the construction of the characteristics-based benchmark portfolios. 20

23 stocks held in common by mutual funds wh similar investment styles. Finally, we include time and industry dummies to control for differences in stock returns over time and across industries, and we cluster standard errors by firm to control for any time series correlation in the regression residuals. Panel A of Table 5 presents the result wh fund-held stocks adjusted abnormal returns as the dependent variable, while Panel B presents the result wh DGTW characteristics-adjusted abnormal returns as the dependent variable. Before we investigate the effect insiders arbrage activies may have on stock returns, we first separately examine the price impact of mutual fund flow-driven trades and that of insider trading. The result in column (1) shows that Forced is negatively correlated wh future abnormal returns during quarters t+1 to t+8, confirming the evidence in Coval and Stafford (2007) that mutual fund flow-driven trades are followed by significant return reversals. Since prices of stocks subject to outflow-driven fire sales are pushed downwards, this finding suggests these stocks realize greater abnormal returns in subsequent quarters than do stocks that are targets of inflow-driven fund trades. Similarly, significant return reversals are observed for quarters t+5 and t+8 following mutual fund outflow-driven fire sales and inflow-driven purchases. On the other hand, we do not find Unforced to be significantly related to future abnormal returns, consistent wh the finding in Coval and Stafford (2007) that aggregate mutual fund trades driven by other factors than extreme flows do not cause return reversals. 8 Column (2) reports results for a model similar to that in column (1), except that Insider_Buy is included as an addional explanatory variable. Insider_Buy is a dummy variable that takes the value of 1 if net insider demand is greater than or equal to zero in quarter t, and is 8 Note that a negative coefficient on Past Return is consistent wh the return reversal subsequent to the inial price momentum as the dependent variable is abnormal returns in the following 24 months. 21

24 zero otherwise. The coefficient on Insider_Buy is significantly posive, suggesting that insider trading is informative about future returns. Finally, we investigate the price impact of insider trading when insiders take advantage of the temporary mispricing following mutual fund flow-driven trades by interacting Forced wh subsequent insider trading. Specifically, we create an indicator variable Forced_Sell (Forced_Buy), which is equal to -1 (1) if a stock has been heavily sold (bought) by funds experiencing extreme flows during the quarter, and 0 otherwise. Similarly, we identify net insider purchase (sale) by an indicator variable Insider_Buy (Insider_Sell), which is equal to 1 if NID is non-negative (negative), and 0 otherwise. We then separately interact Forced_Sell wh Insider_Buy and Forced_Buy wh Insider_ Sell. Although we focus on insider trading in response to mutual fund flow-driven price pressure, is possible that managers also take advantage of this mispricing in corporate decisions since Jenter (2005) shows that insider trading activies are closely related to the firm s capal structure changes. To control for the confounding effect of transactions in the corporate account that can impact the firm s subsequent abnormal returns, we consider the firm s concurrent net stock issues and their relation to mutual fund flow-driven price pressure. Specifically, following Fama and French (2008) we measure net stock issue (Net Issue) as the natural log of the ratio of the spl-adjusted shares outstanding in quarter t divided by the spladjusted shares outstanding in quarter t-1. We then interact both Forced_Sell and Forced_Buy wh Net Issue. The results reported in column (3) of Table 5 show that the coefficients on Forced_Buy and Forced_Sell are both negative, suggesting the presence of price reversal following both mutual fund inflow-driven purchases and outflow-driven sales. More interestingly, the results 22

25 show that insider trading against constrained fund trades significantly speeds up the correction of mispricing. Specifically, the interaction between Forced_Sell and Insider_Buy and that between Forced_Buy and Insider_Sell are both significantly posive. These findings imply that when the incidence of mutual fund fire sale is coupled wh the subsequent insider buying activy, the future abnormal returns of the stock is less posive, because the insider buying activy reduces the associated future return reversals. Conversely, when a mutual fund flow-driven purchase of the stock is followed by the insider selling activy, the future abnormal returns of the stock following the insider trading activy is less negative, again because insider selling speeds up the price correction. Columns (5) to (8) of Panel A consider cumulative abnormal returns during quarters t+5 to t+8 as the dependent variable (instead of abnormal returns during quarters t+1 to t+8, as in columns (1) to (4)). This analysis addresses the possibily that price correction may begin a few quarters after the event due to the persistence of instutional price pressure (Coval and Stafford 2007). The results are qualatively the same. Furthermore, when we use the DGTW characteristics-adjusted abnormal returns as the dependent variable in Panel B of Table 5, we again find insiders arbrage activies to significantly reduce the return reversals caused by flow-driven price pressure. 9 Lastly, in columns (4) and (8) of each panel, we re-examine the price impact of insider trading on mutual fund flow-driven mispricing while controlling for corporate net secury issues. Our main conclusion remains unaffected. While we find that greater net stock issues cause significantly lower future abnormal returns, we do not find their interaction terms wh mutual 9 Since the quarterly DGTW characteristics-adjusted return is the stock return net of the return of a portfolio of stocks wh similar size, book-to-market, and momentum characteristics at the beginning of each quarter, would seem that the loadings on LogSize, B/M, and Past Return should be insignificant. However, this will not be the case since these stock characteristics are measured as of quarter t while the abnormal returns are measured during quarters t+1 through t+8. 23

26 fund forced purchases and sales to be significant. Overall, we conclude that insider trading against the flow-driven fund trades helps arbrage away the temporary mispricing and speed up the process of price correction. V. The Effect of Mutual Fund Flow-Driven Trades on the Timing of Option Grants 1. Option Grants in Response to Mutual Fund Flow-Driven Mispricing So far we have shown that insiders adjust purchases and sales in their personal account to take advantage of the temporary mispricing caused by extreme inflow or outflow-driven trades. Since managers are awarded stock options that account for a significant portion of their total compensations, would be interesting to examine whether stock options granted to insiders are timed to explo mutual fund flow-driven price pressure. We obtained data on option grants from Thomson Financial Insider Filing Data Files. We focus on the post-1994 period for this analysis because there are too few observations for option grants in the earlier period, as stock options were not yet a popular form of executive compensation at that time. To investigate whether firms time option grants in response to the flow-driven mutual fund trades, we run the following log regression: Log( Option Grant = 1) = α + β Forced β Past ROA β2 1 + β3 / 4, t 1 LogSize + β Unforced ε B M 1 + β Past Return 4 4, t 1 + (9) where the dependent variable Option Grant is a binary variable that takes the value of 1 if firm i has granted options to s officers during quarter t, and 0 otherwise. Forced is a discrete variable which indicates mutual fund flow-driven purchases (+1) or sales (-1). Since Smh and Watts (1992) show that large firms and growth firms are significantly more likely to use option grants 24